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10 October, 2008

Jumping into the Economic Fray

Okay. People obviously are paying a lot of attention to the market, and the economy, and I am starting to do so as well. Up until a few weeks ago, I had zero, or almost zero comprehension of what was going on. I only knew that Fannie Mae and Freddie Mac, mortgage banks, were in trouble, and that it had something to do with giving out bad loans. Then I heard that many banks were failing, and I didn't quite understand why that was happening. And then I heard that insurance companines like AIG were in trouble, and that there was somehow corruption involved.

And the market dropped.

After a couple of weeks of this, it got kind of frustrating having no idea WHY any of this is occurring, so I decided to at least START reading about it, and paying closer attention.

The easiest thing for me to do here is just link you to a few articles that fairly well describe different aspects of the situation. Here are some links:

Historically, mortgages and many loans are very safe money for banks because people usually pay back their loans.

As a result, banks figured out that a good way to make even more money, with even lower risk, is to bundle loans into investsments, and SELL that risk to investors (e.g. as bonds). If the loans are paid back (which they almost always have been), then everyone makes money.

This became such a desirable investment option, that there were not enough loans out there to satisfy the demand for the investments that they comprise

Result: Banks started giving more and more loans, essentially lowering the bar of what it takes to QUALIFY for a loan. These loans become progressively RISKIER investments

Consumers did not know (at least not transparently) that these were bad loans they were investing in, because they were not rated as bad - the ratings agencies called them good - partly due to corruption, and partly due to the fact that they were supposedly insured (by companies like AIG!)

At the same time that all this is happening, the housing market is imploding, and people's homes are losing equity

End game is that the loans were bad, people could not repay, the insurance companies cannot cover the losses, and banks are in trouble.

Making matters worse is the fact that there were large investment pools that were actually betting AGAINST those loans being repaid (i.e. "shorting"), and that has the power to drive the market down even further

Making matters even worse is the fact that so many investors are now people like you and me, who react to changing market conditions with emotions such as, PANIC, and pull their money out, causing further market instability

Making matters even worse than that is the fact that among the panicking masses, there are surely savvy professional investors who are continuing to play the Wheel of Misfortune, and make money via other people's panic! Every time you and I sell on panic, there can be someone else making money betting on the stock price going down.

One interesting thing that was shown to me by a colleague is an index called the Volatility Index (^VIX). This measures the volatility, or instability of the stock market. The measure has been tracked for about 18 years. Presently, the VIX is at an ALL TIME HIGH. See the chart below.

And as if that's not shocking enough, it continues, at this very minute, to climb higher, with today's trading sessions taking it to even higher (steeply) all time highs! This is not good because, among other things, it means that the market is becoming highly reactive - not to the actual conditions of the companies being traded, but to the market itself. During the time I have been typing this blog, it has climbed yet another 2 points. This is absolutely serious shit.

So, what do you do now? Well, that's the hard call. All of the "experts" will always tell you - especially about retirement plans - you need to think about the long haul, and that these are just blips in time. And that we cannot be reactive to market volatility, etc. And all that jazz. But all of that is on the presumption that we do not KNOW what is happening. For instance, if someone told you in August of 1929 that the stock market is about to undergo a 90% slide, would it be "thinking long-term" to leave your money in there? Of course not! While this is NOT the same thing as 1929, there are certainly (or I should say, there WERE certainly) enough indicators that things were about to become bad.

But if you didn't pull your money out, what do you do now? Risk holding it further and watching the market decline further? Would people have predicted 2 weeks ago, that after dropping precipitously, the market would then... continue to drop precipitously? Maybe. Because nothing in the crisis has been resolved... yet.

Below is an article in today's internet, talking about the "What now?" question. It focuses on the point that right now, if you ARE holding your investments, you should at least check to see that you are not doing considerably WORSE than the market as a whole.

One thing to consider, is the idea of "dollar-cost averaging". This is the idea of (typically) buying a little bit at a time, to average what is happening in market conditions. So if you buy, say, $1000 a month into the market, then even if the market continues dropping, you are continuing to buy at a lower and lower price. This is a safer plan than going "all in" but it obviously has risks associated with it as well. I was contemplating the idea of dollar-cost averaging in the opposite direction - i.e. SELLING a certain amount each month until the market hits what "looks like bottom". That way, as the market drops, I could at least be pulling a little bit out at a time, rather than seeing it all lose the maximal value. Again, there are risks with this.

One thing I think is NOT worth doing, is adhering rigidly to the so-called wisdom of staying in it for the long run. This is YOUR money, and you need to do what's best for YOU. And more importantly, I think that the principle of "long run" is if the market is primarily being driven by the economic conditions of the companies in which you are investing. Right now the market is subject to a variety of greater forces, and we are not put our money just in the hands of those companies we've invested, but also in the hands of THE MARKET itself.

If you are curious about what I am doing/did:

After the Fannie Mae and Freddie Mac news came out, I sold EVERY SINGLE stock and mutual fund holding that I had in my retirement plans, and moved the money to either CASH or BOND funds. I did this because I didn't want to get screwed again like I did back in 2000, when I stuck to conventional "wisdom" and watched my portfolio drop almost 40% during a 2 year period. Given the market news, and the pending election, it felt like the right thing to do.

It was PARTLY right. I made a slightly false assumption thinking the bond funds were a safe place, because they have dropped too. But not as much as the market on the whole. Yet.

And I have not done ANY risky gambling on the volatile market. True, I have kicked myself when I see stocks like AIG bouncing up and down 30% in a day, but I am too afraid right now to bet that the upswing is coming, only to be hit with the downswing. Not worth it.